The Asset Market, Money and Prices

1
The Asset Market, Money and Prices

• Part I

2
Overview

• Functions of Money
• Monetary Aggregates and Money Supply
• Portfolio Allocation and Asset Demand
• Demand for Money
• Price Level
• Real Income
• Interest Rate
• Money Demand Function
• Elasticities of Money Demand

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Asset Markets

• The asset market is the entire set of markets in
  which people buy and sell real and financial
  assets, for example, gold, houses, stocks, and
  bonds.
• Money is an asset widely used and accepted as
  payment.

4
The Functions of Money

• A medium of exchange - money is a device for
  making transactions at less cost in time and
  effort.
• A unit of account - money is the basic unit for
  measuring economic value.
• A store of value - money is a way of holding
  wealth.

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The Money Aggregates

• The money aggregates are different measures of
  the money stock.
• M1 consists primarily of currency and balances
  held in chequing accounts.
• M2 is M1 plus personal saving deposits, including
  those with a fixed term, and nonpersonal notice
  deposits.
• M2 is M2 plus accounts at non-bank financial
  institutions, e.g. caisses populaires and credit
  unions.

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• M3 is M2 plus term deposits held by businesses
  and foreign currency holdings of Canadian
  residents.
• Weighted money aggregates may be more useful
  measures of money than are the standard
  aggregates.

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The Money Supply

• The money supply is the amount of money available
  in an economy.
• The money supply is partly determined by the
  central bank.
• Assume that the Bank of Canada sets the money
  supply. In practice it is done indirectly.

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• One way to influence the money supply is
  open-market operations open market purchases
  and sales of government bonds to the public.
• A purchase of government bonds from the public
  increases the money supply. A sale of government
  bonds to the public decreases the money supply.

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• Another way to influence the money supply is to
  purchase and sell government bonds directly to
  the government.
• In effect, when the government finances its
  expenditures by printing money, it induces
  inflation.

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Portfolio Allocation and the Demand for Assets

• A portfolio is a set of assets that a holder of
  wealth chooses to own.
• The portfolio allocation decision is based on
  expected return, risk, and liquidity of an asset.

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Expected Return

• The rate of return to an asset is the rate of
  increase in its value per unit of time.
• The return on a share or stock is the dividend
  paid by the stock plus any increase in the
  stocks price.
• The expected return is the best guess about the
  return on an asset.
• Everything else being equal, the higher an
  assets expected return, the more desirable the
  asset is and the more of it holders of wealth
  will want to own.

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Risk

• An asset has high risk is there is a significant
  chance that the actual return received will be
  very different from the expected return.
• Everything else being equal, a more risky asset
  is less desirable for holders of wealth.

13
Liquidity

• The liquidity of an asset is the ease and
  quickness with which it can be exchanged for
  goods, services, or other assets.
• Money is a highly liquid asset.
• Everything else being equal, the more liquid an
  asset is, the more attractive it will be to
  wealth holders.

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Asset Demands

• There is a trade-off among the three
  characteristics that make an asset desirable a
  high expected return, low risk, and liquidity.
• The amount of each particular asset that a holder
  of wealth desires to include in her portfolio is
  called her demand for assets.

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The Demand for Money

• The demand for money is the quantity of monetary
  assets that people choose to hold in their
  portfolios.
• Money is the most liquid asset but pays a low
  return (zero nominal return).
• The demand for money will depend on the expected
  return, risk and liquidity of money relative to
  other assets.
• The macroeconomic variables that have the
  greatest effects on money demand are the price
  level, real income, and interest rates.

16
The Price Level

• The higher the general level of prices, the more
  dollars people need to conduct transactions and,
  thus, the more dollars people will want to hold.
• Everything else being equal, the nominal demand
  for money is proportional to the price level.

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Real Income

• Higher real income means more transactions and a
  greater need for liquidity, therefore, the amount
  of money should increase.
• The increase in money demand need not be
  proportional to an increase in real income.

18
Interest Rates

• An increase in the expected return on money, i.e
  interest rate on monetary assets, im, increases
  the demand for money.
• An increase in the expected return on alternative
  assets, i.e. i, causes holders of wealth to
  switch from money to higher-return alternatives.

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The Money Demand Function

• Md is the aggregate demand for money
• P is the price level
• Y is real income or output
• i is the interest rate earned by non-monetary
  assets
• L is a function relating Md to Y and i

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The Money Demand Function (continued)

• r is the expected real interest rate
• pe is the expected rate of inflation, it is
  assumed to be fixed

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The Money Demand Function (continued)

• Money demand depends on the interest rate on
  non-monetary assets, which tends to change more
  often and is a likely reason of a change in the
  money demand.

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The Money Demand Function

• Real money demand or demand for real balances is
• The function L that relates real money demand to
  output and interest rates is called the real
  money demand function.

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Other Factors AffectingMoney Demand

• The money demand increases as a result of
• higher wealth
• higher riskiness of alternative assets
• lower liquidity of alternative assets
• lower efficiency of payment technologies.

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Elasticities of Money Demand

• The income elasticity of money demand is the
  percentage change in money demand resulting from
  a 1 increase in real income.
• The interest elasticity of money demand is the
  percentage change in money demand resulting from
  a 1 increase in the interest rate.
• The empirical evidence is that the income
  elasticity of money demand is positive but less
  than one.
• The empirical studies find a small negative value
  (-0.3) for the interest rate elasticity of money
  demand.

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Velocity and the Quantity Theory of Money

• Velocity (V) is nominal GDP (P times Y) divided
  by the nominal money stock (M).
• The quantity theory of money asserts that real
  money demand is proportional to real income (i.e.
  velocity is constant).

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The Quantity Theory of Money

• where k is a constant.
• The real money demand function L(Y,rpe) takes
  the simple form kY.
• This is a strong assumption that velocity is a
  constant, 1/k, and does not depend on Y and rpe.

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Asset Market

• The asset market is in equilibrium when the
  quantity of each asset that holders of wealth
  demand equals the (fixed) available supply of
  assets.
• We assume that all assets may be grouped into
  money and non-monetary assets.
• Asset market equilibrium reduces to the condition
  that the quantity of money supplied equals the
  quantity of money demanded.

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Asset Market Equilibrium

• The sum of all individual demands equals the
  economys total nominal wealth
• Md is the aggregate demand for money.
• NMd is the aggregate demand for non-monetary
  assets.

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• Aggregate nominal wealth is
• M is the fixed nominal supply of money.
• NM is the fixed nominal supply of non-monetary
  assets.

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• Thus, the equilibrium condition is
• If (Md-M)0, then (NMd-NM)0.